Goldman Sachs report on Brazil Banks

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May 9, 2012 Brazil: Banks

Equity ResearchGetting over the hump: Insights from deconstructing auto NPLs bode well for ITUB/BBAS Lax underwriting vs. cyclical NPLs Updating estimates to reflect 1Q, guidance Much of the pressure on asset quality being We revise estimates to reflect 1Q2012 results,

COVERAGE SUMMARY Priceexperienced by the system is being driven by updated macro assumptions, and provision TickerMay 08RatingIn R$NPLs on the auto portfolio originated in late 2010 expense guidance disclosed by banks following Banco BradescoBBDC4.SAR$29.60Neutraland early 2011 (particularly for Itau Unibanco and results. In general, we lower EPS estimates in Itau Unibanco HoldingITUB4.SAR$32.83BuyBanco Santander BrasilSANB11.SAR$15.95NeutralBanco do Brasil). As we get more data from banks 2012 (-2.9% on average) on higher provision Banco do BrasilBBAS3.SAR$27.07Buyon these NPLs (especially 30-day NPLs on the first expenses, and in 2013 (-6.2%) and 2014 (-2.3%) ItausaITSA4.SAR$9.86BuyIn US$installment), it increasingly appears that the driven by lower expected base interest rates Banco Bradesco (ADR)BBD$19.24NeutralItau Unibanco Holding (ADR)ITUB$21.34Buyproblems arose as a result of lax underwriting (which hurt margins). For 2012, we continue to Banco Santander Brasil (ADR)BSBR$10.25Neutralstandards, which were then compounded by a believe the second half could surprise positively. 12-month Target Pricescyclical downturn. This in part explains how NPL Target priceNewPrevious% chgratios could increase even as unemployment Reiterate preference for ITUB and BBAS In R$Banco BradescoR$35.10R$36.00-2.5%reached all-time lows. We adjust our target prices to reflect our new Itau Unibanco HoldingR$39.90R$41.30-3.4%Banco Santander BrasilR$18.90R$19.50-3.1%estimates, on average lowering them by 3%. Itau Banco do BrasilR$34.60R$35.40-2.3%Less pressure from provisions in 2013E Unibanco and Banco do Brasil shares have de-ItausaR$12.10R$12.63-4.2%In US$Both Itau Unibanco and Banco do Brasil have rated on asset quality fears and are trading close Banco Bradesco (ADR)$20.00$20.60-2.9%taken measures to improve origination standards, to the lowest multiples since the 2008 crisis. With Itau Unibanco Holding (ADR)$22.80$23.60-3.4%Banco Santander Brasil$10.80$11.20-3.6%resulting in a significant decline in approval the recovery we increasingly see for 2013, we find

Source: Goldman Sachs Research estimates. ratings. As poorly originated loans become the shares to be mispriced in absolute terms and further past due, they will require more relative to peers, and reiterate our Buy ratings. We

provisions, which will come mostly in 2012. But maintain our Buy rating for Itausa (holding for 2013 we expect much of the pressure to be company composed mostly of Itau Unibanco) and lifted, and consequently results to improve. Neutral ratings for Bradesco and Santander Brasil.

Carlos G. Macedo Goldman Sachs does and seeks to do business with companies +55(11)3371-0887 [email protected] Goldman Sachs do Brasil CTVM S.A. covered in its research reports. As a result, investors should be aware Wesley Okada +55(11)3371-0875 [email protected] Goldman Sachs do Brasil CTVM S.A. that the firm may have a conflict of interest that could affect the Mariana Barros objectivity of this report. Investors should consider this report as only a +55(11)3372-0105 [email protected] Goldman Sachs do Brasil CTVM S.A. single factor in making their investment decision. For Reg AC Jason B. Mollin +55(11)3371-0871 [email protected] Goldman Sachs do Brasil CTVM S.A.certification and other important disclosures, see the Disclosure

Appendix, or go to www.gs.com/research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research

analysts with FINRA in the U.S. The Goldman Sachs Group, Inc.

Global Investment Research May 9, 2012

Brazil: Banks

Overview: Significant value in ITUB and BBAS after breaking down auto NPLs Brazilian large-cap banks (Itau Unibanco, Bradesco, Santander Brasil and government-controlled Banco do Brasil) are the largest financial groups in Latin America. They operate mostly within Brazil, and are exposed to the potential and risks of their home market. The potential lies in the still relatively low level of financial penetration (compared to developed peers), supported by a relatively concentrated market structure. The risks lie in the growing pains of a developing market, including the effects of excessive borrowing and the occasional episode of government intervention. Growing pains in 2012. Developments in 1Q2012 have shown some of these growing pains. Banks are going through a cyclical NPL crisis, which is in part associated with lax loan standards at the end of 2010 and early 2011 (particularly in auto loans). The performance of auto loans originated in this period, when approval rates, loan to value and terms were higher, has been significantly worse than historical averages, leading to a substantial increase in provisioning expenses (especially for Itau Unibanco and Banco do Brasil subsidiary Banco Votorantim). The banks have largely addressed the underwriting issues, and new vintages have shown improvement. While results for 2012 are set to suffer from higher provisions, we expect less pressure in 2013. Profitability should recover in 2013. Based on this, we reiterate our confidence that profitability will normalize in 2013 after a down year in 2012. Normalized provision expenses, partially offset by a base-interest-rate driven decline in margins, should allow ROAs to expand 10-20 bp yoy, and push ROEs close to 20%. The sustainability of ROEs at the 20% level depends largely on the banks' ability to improve operational efficiency, since we continue to believe that margins will contract over the next several years. Favor Itau Unibanco and Banco do Brasil. In this context, we favor the banks that have suffered the most for the recent asset quality concerns: Itau Unibanco and Banco do Brasil. Shares for both banks have experienced a significant de-rating and are now trading at some of the lowest multiples since the 2008 crisis. With the recovery we increasingly see for 2013, we find the shares to be mispriced in absolute terms and relative to peers, and reiterate our Buy ratings. We also have a Buy rating for Itausa, the holding company that has Itau Unibanco as its main asset. We have Neutral ratings for Santander Brasil and Bradesco. Updating estimates and price targets. We update our estimates to reflect 1Q results, new guidance given by management and new macro assumptions with lower base interest rates for 2012 and 2013. Mostly driven by lower NIM and higher provision expenses, we lower 2012E-2014E EPS by on average 2.9%, 6.2%, and 2.3%. The changes to our estimates lead us to adjust our 12-month target prices, which on average decline by 2.8%. Exhibit 1:We update our target prices and estimates for Brazilian large-cap banks 12-month target price2012E EPS2013E EPSMultiplesPrice as % Upside/ % % 2013E 2012E Ratingof 5/08/12PreviousCurrentchangeDownsidePreviousCurrentchangePreviousCurrentchangeP/EP/BVLocal, in R$Itau UnibancoBuy 29.05

Auto NPLs: Separating lax underwriting from the cycle As more data comes out regarding auto finance, we become increasingly convinced that much of the current asset quality problems facing some banks in Brazil (particularly Itau Unibanco and Banco do Brasil) were caused by lax underwriting standards in auto loans, specifically between June 2010 and June 2011. While these problems will likely continue to weigh on earnings over the next two to three quarters, we believe that 2013 should show a marked improvement. The problem: Lax underwriting in late 2010 and early 2011 In mid-2010, real GDP growth for Brazil was above 6% yoy, the outlook for the global economy was improving and Brazilian banks had significant appetite to expand loan books. The main vehicle for this expansion was auto loans, which were perceived to be relatively safe given the real asset guarantee structure of the loans. So banks, led by Itau Unibanco and Banco do Brasil's subsidiary Banco Votorantim, slightly lowered underwriting standards by: (1) increasing terms, (2) lowering loan to value, and (3) increasing approval rates for new loans. Another factor was that banks started migrating away from used car financing, believing it to be higher risk, and moving towards new car financing. However, with most origination focused on that segment, competition led to a further erosion of underwriting standards. This transformation is visible in the metrics for Banco Votorantim's auto loan portfolio. Given that the metrics are for average portfolio, origination trends were likely even more strongly tilted in that direction. We believe that metrics for Itau Unibanco were similar, with the exception that most of the origination was focused on new as opposed to used vehicles. Not surprisingly, system-wide origination of auto loans increased significantly right through the middle of 2011.

Changes to risk-weightings for consumer loans implemented by the Central Bank in late 2010 may have been a contributory factor. They increased the capital requirements for longer duration loans, such as auto finance. To compensate for the additional capital, banks increased lending rates on auto loans while approval rates did not change materially. A final problem was a decline in the value of used cars, which started in early 2010. This decline reduced the incentive of borrowers that obtained loans for new vehicles with high loan to value to pay their installments, given that the value of the down-payment disappeared as soon as the car was driven off the lot. The lower underwriting standards led the banks to give loans to borrowers that should not receive loans, a classic Type II error. The strongest evidence of this is the percentage of first installments past due more than 30 days, which rose significantly in data available for Banco Votorantim. In our view, missing payment on the first installment of a loan by more than 30 days is a clear indicator that the loan will likely never be fully paid. These unpaid first installments eventually became full-blown NPLs, and the 90-day NPL ratio for auto loans nearly doubled since February 2011.

Exhibit 4:Past due first installments on auto loans almost tripled in late 2010 Exhibit 5:...Which was reflected on industry overall NPL figures, which and early 2011 for Banco Votorantim... increased consistently since December 2010 30-day past due first installment for Banco Votorantim auto loans System-wide NPL ratios for auto loans

4.5%6.0%4.0%5.5%3.5%5.0%3.0%4.5%2.5%4.0%3.5%2.0%3.0%1.5%2.5%1.0%2.0%0.5%78888889999990000001111112-0-00-00-0-00-00-0-11-11-1-11-11-1-10.0%cr-0gt-cr-0gt-cr-1gt-cr-1gt-c9999000000000000111111111un-un-un-un-DeFebApJAuOcDeFebApJAuOcDeFebApJAuOcDeFebApJAuOcDeFeb-0-0-0-1-1-1-1-1-1-1-1-1-1-1-1-1-1pt-0vcnbr-1r-1ynl-1gpt-1vcnbr-1r-1ynl-1gp15-30 day NPL30-90 day NPL>90 day NPLSeOcJuJuNoDeJaFeMaApMaJuAuSeOcNoDeJaFeMaApMaJuAuSe

Source: Company data. Source: Brazilian Central Bank. Itau Unibanco and Banco do Brasil were hit the hardest by this. They were the fiercest competitors in the new car market, and where we believe the approval rates for auto loans were the highest. We do not believe Bradesco was as strongly involved, as is shown by the limited pressure on Bradesco's NPLs. Santander Brasil was not operating its auto loan business at full capacity, still integrating operations from the merger with ABN Amro Real. To us, this was an underwriting problem driven by competition and the perception of security created by the real guarantees of auto loans. In a way, it was similar to the unsecured personal loan problems experienced in late 2005 and early 2006, when banks aggressively extended personal loans to non-account holders through non-traditional banking outlets, hoping that the high spreads would offset credit costs. When delinquency proved too strong to handle, banks shut these businesses down, and brands such as Finasa, Fininvest, and Taii lost value. Much like that time, upon perceiving the problem banks have acted swiftly. However, auto loans have a much longer duration than personal loans, prolonging the impact on the balance sheet and income statement. Goldman Sachs Global Investment Research 4 May 9, 2012

Source: Brazilian Central Bank. Source: Brazilian Central Bank. The good news is that the effects of the tougher lending standards had an immediate impact on asset quality. The percentage of first installments past due quickly declined to historical averages for Banco Votorantim, and we believe the same applies to Itau Unibanco. System-wide data started to show a deceleration in the pace of growth in auto NPLs, a trend we believe will intensify throughout the year and lead to lower NPL ratios towards the end of 2012.

4.5%160%140%4.0%120%3.5%100%3.0%80%2.5%60%40%2.0%20%1.5%0%1.0%-20%0.5%-40%899990000111120.0%-00-0-01-1-11-1-10000r-0r-1r-1r-111111112cpcpcpc111011111un-un-un-l--10-1-1-11-11-1-1-11-11-1-1-12-12gt-v-nbr-ynl-gt-v-nbr-1DeMaJSeDeMaJSeDeMaJSeDeMaJuoJuoAuSepOcNDecJaFeMaAprMaJuAuSepOcNDecJaFeMa15-30 day NPL30-90 day NPL>90 day NPL

The bad news is that, despite a visible improvement on the margin, the effects of the nine-month period of poor underwriting will likely still have a negative impact on 2012 results. The duration of the loans means that it takes longer for them to fall off the books. In Brazil, Law 2,682 determines the amount of provisioning for consumer loans depending on how long they have been past due (Exhibit 10). However, for loans with remaining terms that are longer than 36 months, the amount of time past due to provision doubles (Exhibit 11). This means that, unlike shorter-term consumer loans, auto loans are only fully provisioned after 360 days (not 180) and only written off after 540 days (not 360). The non-performing auto book thus stays on the balance sheet for a longer time. An additional complication is that as the terms on the loans decline below 36 months, provisioning must be accelerated so that they comply with provisioning rules for shorter-term loans. This means that even though the amount of time the loan is past due does not change at all, the amount of provisions necessary increases considerably. For instance, for a loan with more than 36 months remaining in term and that is past due 121 days a bank would have to provision 10% of the balance, consistent with a "D" rating. However, the instant the term of the loan declines to 36 months, the provisioning table changes, and the loan would now be classified as "F" and the bank would have to provision 50% of the balance (Exhibit 10). What this means is that even though we expect the absolute amount of NPLs to decline through the end of the year, largely as a result of write-offs from the portfolios originated in late 2010, provision expenses are likely to remain high, as many of the loans given out during the lax underwriting period move to remaining terms of under 36 months and have their provisioning accelerated. This in part may explain the strong provision expense guidance given by Itau Unibanco following 1Q2012 results.

Exhibit 10:The amount of time to provision doubles for loans with remaining Exhibit 11:Declining terms can lead to significantly higher provisioning terms of over 36 months Impact on provisioning of a loan past due 121 days moving from 37 months Provisioning rules under law 2,682 remaining in term to 36Number of days Number of days Percentage of past due (<36 past due (>36 Rating loan provisioned month term) month term) 100100AA 0% 0 0 A 0.5% 0 0 B 1.0% 15 to 30 30 to 60 C 3.0% 31 to 60 61 to 120 D 10.0% 61 to 90 121 to 180 50E 30.0% 91 to 120 181 to 240 F 50.0% 121 to 150 241 to 300 10G 70.0% 151 to 180 301 to 360 H 100.0% over 180 over 360 37 months36 months

Outlook for 2013 provisions seems much better Despite the unfavorable outlook for the remainder of 2012, we have confidence in an improvement for 2013. Early data on new auto loan vintages seems promising, and leading indicators of asset quality point in the right direction. Moreover, by early 2013 most of the problem loans given out at the end of 2010 and early 2011 will have fallen off the books, allowing NPL ratios to improve and provisioning expense growth to decelerate. It is important to separate the cyclical/secular provisioning, which is driven by macro and structural reasons, from the underwriting-driven provisioning, which is the result of lax underwriting standards. Only the latter is fully addressable by the banks, and can produce meaningful improvement in asset quality. Based on this, and the improvements we believe are already in place, we expect provision expenses (particularly for Itau Unibanco) to remain flat in 2013 compared to 2012 (Banco Votorantim represents only a small part of Banco do Brasil's overall provision expenses), and that profitability levels will partially normalize (offset by weaker expected margins).

Exhibit 12:We believe provision expenses in 2012 will be hit by underwriting-Exhibit 13:We have provision expenses for Itau Unibanco flat in 2013, driven provisions that will fade and not show up in 2013 allowing for a recovery in profitability Sample composition of provision expenses Provision expense forecast for Itau Unibanco

1Q2012 review: Weakening asset quality is key theme Results for 1Q2012 were uninspiring, with recurring ROEs declining almost across the board. The defining theme for the quarter was poor asset quality, not only through increasing NPLs but also through a sequential increase in provision expenses, which limited EPS expansion. Loan growth was also weak, in part for seasonal reasons and also driven by lower loan approval ratings by the banks. Margins were mixed, through we believe that lower rates will inevitably lead to some compression through the year. Fee income growth was weak, much of it seasonal. Seasonality on personnel and marketing expenses also helped admin expenses, but an important part of the improvement was driven by efficiency gains. Exhibit 14:Higher provision expenses hurt 1Q2012 results Score card for 1Q2012 resultsDelivered?TotalItemBBASBBDCITUBSANBScoreCommentLoan growth was weak througout, the combination of a seasonally weaker quarter with a Loan growthPassNoNoNo0.5 cyclical downturn.Adjusted for trading, repos and recoveries, Santander Brasil was the only bank to strength Resilient marginsNoNoPassYes1.5 despite declining base rates.Better asset NPLs increased, leading to an even stronger increase in provision expenses. Guidance for NoPassNoPass1.0 qualityfuture quarters was probably worst than the actual results.Fee income In a seasonally weak quarter, fee income growth disappointed across the board with the NoNoNoPass0.5 growthexception of Santander Brasil, where it is the least relevant on a relative basis.Admin expenses Seasonally favorable quarter for expenses (lower personnel and marketing expenses), yet YesYesYesPass3.5 controlcontraction was generally better than expected.Results looked strongest for Santander Brasil, but the differences were not significant. The Total score1.5 1.5 1.5 2.5 similarity was higher provisions and weak asset quality.

Source: Goldman Sachs Research. Looking at the sequential evolution of results, it becomes clear that much of the improvement in 4Q2011 was driven by slightly lower provision expenses, offset by seasonally higher admin expenses, the exact opposite of what happened in 1Q2012. Even though there still is a visible difference in ROA (with Itau Unibanco at the top and Banco do Brasil at the bottom), ROEs seem to be converging slightly below 20% (the exception is Santander Brasil, where the leverage is much lower). We still see pressure on ROEs in 2Q2012, with provision expenses still high. However, we expect asset quality to start improving in 2H2012, lowering provision expenses, though partially offset by weaker margins. See Exhibit 15. Goldman Sachs Global Investment Research 8 May 9, 2012

Lower base rates continue to have a negative Provision expenses increased across the board, 1Q tends to be seasonally favorable for expenses ROA in general declined again sequentially, hurt effect on NII, with little relative help from trading back to the levels of mid-2011, on the back of a and negative for fee revenues, and 1Q2012 was by higher provision expenses. There were not gains. The outlier was Santander Brasil, though slight increase in NPLs. NPL creation also no exception. On the expense side, however, we material changes to leverage, with the possible we find it unlikely that NIM will withstand the increased, maintaining the trend from late 2010. believe part of the improvement was in addition exception of Bradesco. ROE seems to converging impact of lower base rates in 2H2012. We expect improvement in 2H2012. to the seasonal trend. at below 20%, with improvement only in 2H2012. Trading gains (ex-Banco do Brasil, R$ mn) Provision expenses to average loans Fee revenues to average assetsLeverage3,000-9%4.0%18X-8%2,5003.5%16X-7%-6%3.0%14X2,000-5%2.5%12X-4%1,500-3%2.0%10X1,000-2%1.5%8X-1%5000%1.0%6X2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q122Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q122Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q120Itau UnibancoBradescoSantander BrasilItau UnibancoBradescoSantander BrasilItau UnibancoBradescoSantander Brasil2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12